Quick-change artists

Minimizing 'out of market risk' when changing mutual funds

BOSTON (MarketWatch) -- Ed H. in Huntington Beach, Calif., recently read through a proxy statement for the Gateway fund and decided it was time for a change.

The fund, which he owned in an individual retirement account, was part of a corporate merger. "They are adding a 5.75% front-end load for new investors," Ed said. "Fees will be raised after two years. Although the fund management will remain, I am not sure that their hearts are in it."

And so, the 53-year-old investor went looking around for a replacement, settled on Oakmark Equity & Income and pulled the trigger on the sale.

"And wouldn't you know it, they sold my shares on Jan. 22, so I missed the next day's big gain of 300 points on the Dow," said Ed. "So, I thought that I made a smart move, but it turned out to be a stupid move."

Not quite.

Ed upgraded to a fund that most analysts would say is better. It has a better track record, better ratings and lower costs. But he did fall victim to "out of market risk," the chance of missing out on a big gain while making a routine transfer of funds.

Investors can minimize the risk by making the process as quick as possible. But they should also follow the advice of behavioral-finance researchers, who say the best way to deal with missing random market days while improving a portfolio is to "get over it."

Ed's IRA money was out of the market for a day when Gateway
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gained 1.66% and the Oakmark fund
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was up 0.35%. While those gains would have been nice, it's not like's he'll reach early retirement age and come to the conclusion that he can't call it quits because of that one missed day.

What's more, if Ed's transaction had been processed six days earlier, he would have missed a 1.74% decline in Gateway, or a 1.4% loss in Oakmark Equity & Income. That would not have made his move smart; his portfolio upgrade was wise based on its own merits, not on daily price changes.

"The market was not lying in wait to stick it to this fellow, but it sure does feel like that to all of us sometimes," says Meir Statman, a professor of finance at Santa Clara University who studies behavioral finance.

"When the anesthetic of time has set in -- if he remembers this at all -- he's just going to chuckle to himself about how chagrined he felt about missing the one day. ... And if his new fund does what he expects and performs better, then owning the new fund -- and missing a few days -- will have been worth it."

No way around it

Out-of-market risk is unavoidable in mutual fund transfers. Unlike a stock or an exchange-traded fund, a mutual fund does not trade minute-by-minute and is only priced at the end of the trading day.

If a sell order hits a fund on a Monday morning, the transaction will be completed at the day's closing price. But even if the money to buy the replacement fund is moved electronically -- since it travels after the market close -- you can only get the next traded price on the new fund, which is Tuesday's closing price. It's as if the fund crossed the international date line and Tuesday's trading -- good or bad -- just evaporated into thin air.

In practice, however, transfer times can be a lot longer. In a rollover situation, a fund cuts the shareholder a check; the money can be moved directly to another fund company or can go to the investor to be forwarded to a new account (which must be done within 60 days to avoid tax complications). The money is out of the market for as long as it takes the check to move from one place to the next.

In a direct asset transfer, money moves electronically from one fund to another, and the out-of-market time can be as little as a day.

Processing lags, where transactions take days to complete, are annoying but don't add to out-of-market days; the money stays invested until the transaction is authorized.

Generally speaking, dealing directly with the firm that is receiving the money -- and allowing it to control the transfer process -- keeps delays to a minimum.

Dollar-cost averaging the transfer by selling and buying pieces of the stake over time makes no sense in a case like Ed's because he sees the transfer as an upgrade and he'd be stuck with a lesser fund; moreover, each smaller transaction still comes with some unforeseeable day that gets missed.

"This is a really tough time to make even a simple transfer, because there is so much volatility that with every passing day, that it can be hard to think rationally and strategically about your financial plan," says Donald MacGregor of MacGregor-Bates, a Eugene, Ore., firm that researches judgment and decision-making.

"Focus on your long-term strategy and doing what's right; sooner or later, you'll have to pull money out, and the time will be right because you say it's the right move, not because of what the market does on that day."

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